Differential Analysis Concepts

1. Relevant Versus Irrelevant Benefits and Costs

Differential analysis is a decision making process that focuses on the costs and benefits related to each of the potential options available. In this process, each alternative’s added revenues and costs are compared and examined to identify which option will have the preferred financial impact on future operations.

Costs can be classified as either relevant or irrelevant, on the basis of their impact on decision-making. Most costs a company incurs while producing a product or providing a service should be taken into consideration. These are relevant costs, which are the costs that will impact a decision and should be considered a necessary input by management when making decisions. In conjunction with the relevant costs, potential relevant benefits should be taken into consideration as well. Relevant benefits are the additional earnings or perks of choosing one alternative versus another.

EXAMPLE

If a company is considering the purchase of a new machine used in the production of their products to replace an older model, relevant costs would include the price of the new machine, the cost to train employees on how to operate the new equipment as well as the cost to dispose of the old machine if it was not being sold. The relevant benefits would include the proceeds earned if the company was able to sell the old machine, as well as the potential reduction in materials and labor from using more efficient updated equipment

Irrelevant costs are those that should not be considered when making decisions. These costs will not be affected by this decision, no matter which option is selected. Benefits to the company that would not change as a direct result of the decision should also be ignored, these are referred to as irrelevant benefits. When management accurately classifies costs as relevant and irrelevant, they are able to save time by only focusing on data that is useful as well as avoiding information that might lead them to incorrect assumptions.

One form of irrelevant cost is sunk costs. Sunk costs are costs that have already been incurred and will not be regained in the future. Effectively, sunk costs will not impact future money paid or revenue earned; therefore, they should never be considered when choosing between potential options.

EXAMPLE

Continuing with the previous example of the purchase of a new machine. The cost of the old machine that would be replaced if the company chose to purchase the new equipment would be considered a sunk cost. That purchase has already been made and that money has been spent with no way of recovering it, which is why it is classified as sunk.

did you know

You may have heard of the sunk cost fallacy. This is a common phenomenon where people and organizations will remain committed to a path or a decision because they are heavily invested in it, even when it is clear that a different path or decision would be a better choice. This common fallacy's name comes from the accounting concept of sunk costs! Although this fallacy is often invoked in interpersonal contexts (you've put so much work into this relationship, so you can't give up on it now!) it is easy to see how it could come into play in a business context too. If management is reluctant to replace an old machine because the old machine was costly to purchase, even if it no longer meets the company's needs, that would be an example of the sunk cost fallacy because management would be prioritizing irrelevant sunk costs over relevant costs.

terms to know

Differential Analysis

A decision making process that focuses on the costs and benefits related to each of the potential options available.

Relevant Costs

Costs that have an impact on a decision and should be considered a necessary input by management when making decisions.

Relevant Benefits

The additional earnings or perks of choosing one alternative versus another.

Irrelevant Costs

Costs that should not be considered when making decisions.

Irrelevant Benefits

Benefits that would not change as a direct result of the decision.

Sunk Costs

Costs that have already been incurred and will not be regained in the future.

2. Differential Revenue and Costs

Differential revenue is a relevant benefit that represents the difference in future revenue from choosing one option instead of another. When evaluating the projected results between two options, management will carefully estimate the additional revenue to be generated by each option. The difference between the revenue generated from each option is the differential revenue.

Differential costs are the differences in cost that arise from choosing one alternative over another. One form of differential cost is avoidable costs, which is a cost that can be completely eliminated by choosing one option as opposed to another.

EXAMPLE

There are options when it comes to ordering food. You can call ahead and pick it up, or you can have it delivered by a service such as DoorDash. Both options will get you the same food and you can eat in the comfort of your home. However, ordering from a food delivery service comes with a delivery fee which can be eliminated if you were to choose to pick up the food, which makes the delivery charge an avoidable cost.

For certain decisions, revenues do not differ between alternatives. Under those circumstances, management should select the alternative with the least cost. In other situations, costs do not differ between alternatives. Accordingly, management should select the alternative that results in the largest revenue. Many times both future costs and revenues differ between alternatives. In these situations, the management should select the alternative that results in the greatest positive difference between future revenues and expenses (costs).

EXAMPLE

To illustrate relevant, differential, and sunk costs, assume that Joanna Bennett invested $400 in a tiller so she could till gardens to earn $1,500 during the summer. Not long afterward, Bennett was offered a job at a horse stable feeding horses and cleaning stalls for $1,200 for the summer. The costs that she would incur in tilling are $100 for transportation and $150 for supplies. The costs she would incur at the horse stable are $100 for transportation and $50 for supplies.

If Bennett works at the stable, she would still have the tiller, which she could loan to her parents and friends at no charge. The tiller cost of $400 is not relevant to the decision because it is a sunk cost. The transportation cost of $100 is also not relevant because it is the same for both alternatives.

These costs and revenues are relevant:

	Performing tilling service	Working at horse stable	Differential
Revenues	$1,500	$1,200	$300
Costs	150	50	100
Net benefit in favor of tiling			$200

Based on this differential analysis, Joanna Bennett should perform her tilling service rather than work at the stable. Of course, this analysis considers only cash flows; nonmonetary considerations, such as her love for horses, could sway the decision.

terms to know

Differential Revenue

The difference in future revenue from choosing one option instead of another.

Differential Costs

The difference in cost that arises from choosing one alternative over another.

Avoidable Costs

Cost that can be completely eliminated by choosing one option as opposed to another.

3. Discretionary Versus Committed Fixed Costs

In many situations, total variable costs differ between alternatives while total fixed costs do not. Before studying the applications of differential analysis, you must realize that: (1) Two types of fixed costs exist. (2) Opportunity costs are also relevant in choosing between alternatives.

For this reason, we discuss committed fixed costs, discretionary fixed costs, and opportunity costs before concentrating on the applications of differential analysis.

think about it

Suppose you are deciding between taking the bus to work or driving your car on a particular day. The differential costs of driving a car to work or taking the bus would involve only the variable costs of driving the car versus the variable costs of taking the bus.

But suppose the decision is whether to drive your car to work every day for a year versus taking the bus for a year. If you bought a second car for commuting, certain costs such as insurance and an auto license that are fixed costs of owning a car would be differential costs for this particular decision.

Up to this point, we have treated fixed costs as if they were all alike. Now we describe two types of fixed costs—committed fixed costs and discretionary fixed costs.

Committed fixed costs relate to the basic facilities and organizational structure that a company must have to continue operations. These costs cannot be changed in the short run without seriously disrupting operations. In the short run, these costs are not subject to the discretion or control of management. These costs result from past decisions that committed the company for several years.

EXAMPLE

Examples of committed fixed costs are leases on buildings and equipment, salaries of employees with long-term contracts, and prepaid insurance policies. For instance, once a company constructs a building to house production operations, it is committed to using the building for many years. Thus, unlike some other types of fixed costs, the depreciation on that building is not subject to management's control.

In contrast to committed fixed costs, management controls discretionary fixed costs from year to year. Each year management decides how much to spend on advertising, research and development, and employee training or development programs. Because it makes such decisions each year, these costs are under management's discretion. Management is not locked in or committed to a certain level of expense for longer than one budget period. In the next period, management may change the level of expense or eliminate the expense completely.

To some extent, management's philosophy can affect which fixed costs are committed and which are discretionary.

EXAMPLE

Advertising can be either a discretionary fixed cost or a committed fixed cost. If a company adjusts its advertising expense according to its needs, advertising would be a discretionary fixed cost. If the same company enters into a multi-year contract with an advertising agency, advertising now becomes a committed fixed cost.

When almost all of a company's fixed costs are committed fixed costs, it has more difficulty reducing its break-even point for the next budget period than if most of its fixed costs are discretionary. A company with a large proportion of discretionary fixed costs may be able to reduce fixed costs dramatically in recessionary periods. By running lean, the company may show some income even when economic conditions are difficult. As a result, the company may enhance its chances of long-run survival.

terms to know

Committed Fixed Costs

Fixed costs that cannot be easily eliminated or have a legal obligation to for the foreseeable future.

Discretionary Fixed Costs

Short-term fixed costs that can be reduced or completely eliminated without profoundly impacting operations or earnings.

4. Opportunity Costs

Differential costs and benefits can be quantitative, meaning that we can measure the impact in dollars, or qualitatively, meaning we measure the value in quality or the perception of its value. While both are important, we tend to focus on the quantitative aspects of a business decision. However, in many circumstances, it is important to analyze what has been given up by choosing one option over another which can be quantitative or qualitative. In other words, we suffer from FOMO, fear of missing out. The benefit that was lost by choosing one alternative over another is called the opportunity cost.

Companies do not record opportunity costs in the accounting records because they are the costs of not following a certain alternative. Thus, opportunity costs are not transactions that occurred but that did not occur. However, opportunity cost is a relevant cost in many decisions because it represents a real sacrifice when one alternative is chosen instead of another.

think about it

Making tough choices is something that managers have to do. Imagine you are a general manager of a professional sports team, and your team is awarded the first pick in the draft. Do you choose the number one college prospect, do you trade the first pick for more picks in later rounds, or do you trade the first pick for a veteran player? Whichever choice you make, the options you did not choose are considered opportunity costs.

term to know

Opportunity Cost

The benefit that was lost by choosing one alternative over another.